Finance 101 – The Dunning-Kruger Effect

foolishness

In An Essay on Criticism, the famed English poet Alexander Pope wrote:

“A little learning is a dangerous thing;

Drink deep, or taste not the Pierian spring:

There shallow draughts intoxicate the brain,

And drinking largely sobers us again.”

The Pierian spring, refered to by Pope represents knowledge of the arts and sciences, with the intention of warning readers of the dangers of overestimating your abilities in a domain you don’t have much experience in. A few centuries later, two American psychologists formalised Pope’s observations with a theory known as the Dunning-Kruger effect, which is best summarised by the chart below.

dunning-kruger effect

The American investor Henry Kaufman once said that there are two people who lose a lot of money: those who know nothing, and those who know everything. When it comes to investing (especially property investing), having a degree of certainty is usually a red flag that you are underestimating the risk of your investment. If you or someone who manages your money feels certain about an investment, keep in mind a quote from Voltaire “Doubt is not a pleasant condition , but certainty is absurd”.

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